Empire State Implosion

The financial meltdown and the welfare state.

Updated Nov. 13, 2008 12:01 a.m. ET

The global credit panic has swept away many illusions, and we're about to find out if that includes those of the politicians who have feasted for years on Wall Street tax revenues. Ground Zero is New York, which has lived a tax-and-spend fantasy thanks to the long bull market and "progressive" tax rates. Reality is now biting.

The financial services industry employs between 2% and 3% of nongovernment workers in New York, the same as it did in the late 1970s. What's changed is the share of total wages in the state represented by Wall Street jobs, which had skyrocketed to nearly 20% last year from a little over 2% in 1977.

"This is 212,000 people making nearly $80 billion in wages and salaries last year," explained E.J. McMahon of the Manhattan Institute at a recent panel discussion on the financial crisis. "This is all taxed at the margin, so it plays an outsized role in the state's finances." This is also the dirty little secret of highly "progressive" tax rates: They make a state dependent on relatively few taxpayers.

Further Reading

The financial industry doubled its percentage of the national economy in the 1980s, and did so again between 1990 and 2006. As Wall Street wages have grown, so has New York's dependence on revenue from the personal income tax. In 1977 personal income taxes represented less than 45% of all state taxes. In 2007 they represented about 60%. And for the past 30 years, inflation-adjusted state spending has tracked closely with booms and busts on Wall Street. According to John Cape, a former state budget director, about 45,000 New York taxpayers provide the state "with anywhere from 20% to 30% of total income tax receipts."

New York City has also done little to decrease its addiction to revenue from a single industry. Mayor Michael Bloomberg missed the chance to use 9/11 as an opportunity for reform, and he's declined to challenge public unions over pay and benefits. Bigger and bigger budgets have been submitted and approved as though record Wall Street profits would never end. The financial industry is 14% of gross city product. In 2006, New York City received 50% of its personal income tax revenue from the top 1% of earners, many of whom work in finance.

During previous downturns Albany has resisted structural reforms. Instead of lessening the state's dependence on this narrow slice of the tax base, lawmakers have been content to wait for Wall Street to come roaring back. To cover the rising costs of debt payments, school aid, Medicaid, pensions and other budget drivers, they've raised taxes, sometimes temporarily but often permanently.

It would be a tragic mistake to view the current downturn as merely another cyclical blip. It may take Wall Street years to come back, and once it does it certainly won't look the same. Fewer big global banks are likely to emerge from the ashes; and while they will be better capitalized, they will also be more highly regulated. More reasonable leverage ratios mean less risk-taking and less profit even in good times. Bonus pools are likely to be anemic for some time.

New York's revenue coffers are set to take a hit. The only question is how big. The state budget deficit is already projected to be $1.5 billion in the current fiscal year, and Governor David Paterson estimates it could grow to $14 billion over the next two years if nothing is done.

To his credit, the Democratic Governor is trying to force Albany to confront its addictions. He's said that a tax hike -- even one targeting only the "rich" -- would be damaging. Mr. Paterson is urging labor unions to renegotiate contracts on behalf of public employees. And he's proposed trimming as much as $2 billion from this year's budget, including cuts to health care and education.

Naturally, union officials and hospital advocacy groups are balking at the Governor's requests and pushing for tax increases, but out-of-control education and Medicaid spending is what has fed the state's structural deficit. New York spends more money per pupil ($14,000) than any other state. Its only rivals are New Jersey and Connecticut and all three are at least 40% above the national average. The state's Medicaid costs of $2,260 per resident are twice the national average and equal to what Texas and Florida spend combined.

If New York wants to make sure a rejuvenated financial industry returns to Wall Street, it should be looking to reform its steeply progressive tax code. A leaner, more risk-averse and heavily regulated finance industry will be all the more sensitive to the high cost of doing business in New York. The Big Apple already imposes the highest personal income tax rate of any jurisdiction in the country (10.5%). And it's significantly higher than neighboring New Jersey (8.97%) and Connecticut (5%).

The financial industry has been having a painful reckoning with more realistic assessments of risk. New York's politicians need a similarly rude awakening.

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